Utilities deliver and dispose of the vital needs and functions of society. As such, they are prized by investors for their stable, non-cyclical attributes. But now, more of Europe's energy utilities are slipping towards lower, riskier ratings. Market liberalisation is driving the change, and the leaders have responded with aggressive cross-border, multi-utility consolidation strategies. Quentin Carruthers reports on how the capital markets are funding this increasingly competitive industry
After the destructive events of September 11, a rapid flight to quality is what you would expect, and strong, defensive utility bonds fit the bill. French electricity monopoly Electricité de France is top of analysts' safe utilities list and, as it so happens, EdF is in the process of marketing its second (and last) benchmark bond of the year, a decision made back in March and still being pursued.
Starting in Germany, the roadshow takes in Paris and London before finishing in Spain on Tuesday. But even in the case of this Aaa/AAA bond, EdF's head of financial operations and strategies, Vincent DeRivaz, remains wary. "We have been keeping our cool in these difficult times," he says. "Expect a long duration, but the market will decide and we are very cautious about just how the market will respond." Similarly, the market will be left to decide just how much will be issued, although DeRivaz indicates that it should be over Eu750m: "If conditions allow us to go beyond that, we shall be pleased."
The lead managers of the euro denominated bond, UBS Warburg, Merrill Lynch and Crédit Agricole Indosuez, will impress upon investors how recent events have strengthened the investment argument. But apart from that, it seems that the credit story will remain little changed from EdF's roadshow for its £650m sterling issue back in July.
Accurate pricing of the EdF bond will prove trickier than usual, as trading has been so thin, with more than one banker describing conditions as "ugly". The widening of bid/ offer spreads has inhibited switch trading, and while utility spreads have held up better, secondary volumes have been too low to give a reliable price measure. Jeffrey Burch, a fixed income analyst at Morgan Stanley,says that while he is comfortable with the utility sector as a whole, there are no "slam-dunk" switch trades to recommend. "Given that bid/offer spreads have widened dramatically, we would recommend outright purchases or sales rather than switch trades," he says.
The successful resurrection and pricing of Innogy's euro/sterling transaction last week has failed to drag the remaining, stalled utility issues to market. Bankers close to the Powergen and Centrica deals report that while the intention is to continue with their roadshows, both of which were interrupted on September 11, the situation is being monitored daily.
At Innogy, group treasurer David Beynon says that the company was very pleased to complete its issue, having initially been advised by its lead managers, Deutsche and Schroder Salomon Smith Barney, to "wait and see". Innogy has drawn heavily on the financial markets this year, including another dual tranche euro/sterling transaction in May. "We have no further financing requirements," says Beynon.
Innogy has been warmly received by analysts across the board. "We like Innogy," says Adrien Fourcade, at BNP Paribas. "It has a good credit story, although it is still struggling to achieve synergies." Innogy's story is further enhanced by suggestions that it could be taken over by a mightier and higher rated German company, such as RWE, in the near future.
Deep German pockets
RWE has proved to be the leading utility issuer of international bonds so far in 2001, topping the tables with four issues totalling just over $3bn equivalent. Like its rival German utility, E.On, RWE is acquisition hungry. E.On has an outstanding recommended bid to take over the UK-based utility Powergen that is now almost certain to be approved by US regulators, which have had to consider the competitive position regarding Powergen's own recently acquired, Kentucky-based subsidiary, LG&E Energy.
Meanwhile, on September 17, RWE announced an agreed takeover bid for American Water Works (AWW). The news triggered immediate action from Moody's and Standard & Poor's, the latter putting RWE's AA- ratings on CreditWatch negative. Although the AWW acquisition could be partly funded through possible new debt issuance in addition to the use of existing funds and disposal of non-core assets, the deal must pass muster with 22 US state regulators. The timeframe for completion of the deal is anything up to two years.
There is uniform expectation that RWE's credit rating will continue to slide downwards, in the best possible way, as it continues to leverage its balance sheet in favour of further acquisitions, mostly in the US. The Essen-based company has just released its annual results for the fiscal year to June 30, 2001. Operating results were increased by a record 41% to just under Eu4bn, with 14% of that total delivered by the 7-1/2 months' results of RWE's new water division, based on the acquired Thames Water business. One analyst who attended the results presentation was impressed by the methodic approach of RWE: "They have a carefully studied, multi-utility approach and they do their homework."
The backstop rating targeted by RWE is A+ but, suggests the analyst, issuers as popular as RWE can get away with pricing bonds tighter than the outlook, on the back of strong investor demand.
"Euro fund managers are still building out their portfolios," says the analyst, "and if you are a German fund manager, you must have RWE on your books. Furthermore, when you are tracking the indices, big utility issues will have to be included."
Event and execution risks
RWE and E.On demonstrate some of the risks of downgrade and occasional opportunities of upgrade associated with M&A in the world of European utilities. Consolidation activity, and the associated financing requirements, is one of main drivers in an overall negative credit trend towards low single-A/high triple-B, releasing debt financing and moving to a point where cost of capital is considered most efficient. Anthony Flintoff, a utilities rating analyst at Standard & Poor's, commented in his most recent review of the sector that in the light of changes taking place in the industry on a global basis, "it could be possible to mount an argument placing all utilities on CreditWatch at the moment".
Another risk, however, is execution risk once those acquisitions have been made. Vattenfall, the leading Swedish utility that has built up a strong presence in the German market behind RWE and E.On, is considered to be particularly exposed to execution risk. Moody's was concerned enough to issue a two notch downgrade from A1 to A3 with negative outlook, and Vattenfall has just announced that it has discontinued its co-operation with Mirant, with whom it jointly owns and manages Berlin utility Bewag.
Vattenfall remains convinced that the creation of "Neue Kraft" even without Bewag is an attractive concept, which has been developed in a natural way out of the upheavals on the German energy market. "Vattenfall did not manage to reach agreement with Mirant on the continuation of the integration process," said Vattenfall in a statement.
Vattenfall was one of the two other utilities (Spain's Unión Fenosa being the other) to have their bond roadshows interrupted on September 11, just as it was on the verge of pricing. The issue, managed by ABN Amro, has not yet returned to the market. Jens Jantzen, an analyst at Bear Stearns, says: "Execution risk is very important. It is easy enough to buy, but more difficult to integrate and streamline businesses particularly involving different cultures. Every time bondholders face a risk, they should ask for a premium."
ScottishPower, too, is another utility widely considered to be facing execution risks.
Big five, and Birka
A big five of European utilities is expected to emerge by the end of 2005, with an estimated Eu100bn spent on M&A consolidation activities. They are: France's EdF, Italy's Enel, Germany's RWE and E.On, and Spain's Endesa.
At the other end of the scale are companies such as Birka Energi, which has steadily built up a recognised name in the capital markets and continues to expand its financing ambitions. Named after an ancient Viking city, Birka is Sweden's third largest energy utility (Vattenfall being the largest) and has no plans to expand beyond its domestic markets. It has maintained its Baa1/BBB+ ratings for the last three years, ever since it first accessed the bond markets. "We think this a good ratings, which gives us flexibility as well as rewarding the investors," says Lars-Håkan Ellenius, Birka's chief financial officer, adding: "We have told the same story for the last three years."
Seventy per cent of Birka's debt is now funded in the capital markets, including a Eu1.5bn EMTN programme, recently increased to Eu2bn. The target of the programme, says Ellenius, "is to reach a broad investor base outside Scandinavia".
Birka is 50% owned by the City of Stockholm and 50% owned by Fortum Power (itself 75% owned by the Finnish state), and its business strategy is focused purely on its domestic Nordic markets which, says Ellenius, "is likely to continue as long as Birka has the same ownership".
US restructuring opportunities
There are few business risks associated with Europe's mature, regulated utility networks, namely the high voltage transmission, water and sewerage monopolies. The National Grid Group (NGG) is one such monopoly, and its management has been seeking out challenges further afield. So far in 2001, NGG has been the second largest issuer among European utilities of bonds in the international markets, raising just over $2.5bn equivalent through five issues to help finance US acquisitions.
NGG's latest acquisition is Niagara Mohawk, the second largest combined electricity and gas utility in New York State. Full regulatory approval of the deal is hoped for by the end of the year. The Niagara Mohawk business will double the size of National Grid USA. Martin O'Donovan, group treasurer at NGG, explains: "Although we have taken on board extra gearing, the acquisition is very cash positive and in the absence of any other acquisitions will pay off the debt."
However, NGG is keen to make further acquisitions, and O'Donovan believes that as long as they are modest, there is sufficient debt capacity within NGG's A2/A rating band to take them on. "We are keen to maintain our credit rating broadly where it is," he adds.
And as the US market moves away from its highly regulated, vertically integrated utility structures, NGG has also succeeded in picking up a service contract to operate Alliance RTO, one of the US's newly consolidated transmission networks, which serves 11 states in the Midwest. Regulatory approval is expected by December 15. Because of long term incentive-based arrangements in the contract, there may be a case to invest in network improvements.
NGG is not the only UK-based utility seeking to expand into the US market and capitalise on restructuring opportunities. Other companies include British Energy, Powergen and ScottishPower. Similarly, the major Iberian utilities, such as Endesa, exploit their cultural links with Latin America. Endesa is the largest electricity group in Latin America, with market leadership in Chile, Argentina, Colombia and Peru.
EdF remains the strongest of the European, even global, utilities. But the French state, owner of EdF, has been criticised for blocking (along with Germany) the European Council of Ministers' attempt in March to endorse a timetable proposed by the Commission for fully liberalizing Europe's gas and electricity markets by 2005. While France drags its feet, say critics, EdF is able to take advantage of liberalisation in neighbouring markets in order to build strategic stakes, while at the same time it virtually monopolises its own domestic market. However, EdF points out that the liberalisation process has been effective since 1999, and that the recent electricity capacity auctions, in which more than 20 bidders competed, demonstrates its success and credibility. In the meantime, EdF's secure leadership in its domestic market and strategic position as a European utility hub continues to impress. *
|Top bookrunners of all international bonds for European Utilities, 2001(September 25, 2001)|
|Rank||Lead manager||Amount $ m||No of issues|
|4||Dresdner Kleinwort Wasserstein||1,436.70||3|
|7||Salomon Smith Barney||1,078.40||5|
|12||Royal Bank of Scotland||568.06||4|
|14||Cr?dit Agricole Indosuez||481.40||4|
|15||Credit Suisse First Boston||327.40||4|
|18||Natexis Banques Populaires||211.61||1|
|Source: Dealogic Capital Data Bondware|
|Based on data for western Europe and Nordic regions|